“‘Bout Working All Summer, Just to Earn a Dollar”[1]

As measured by years, it wasn’t that long ago that the markets abhorred central bank intervention.  As measured by perception, the days that were without meddling and manipulation seem like they should be preceded by “BC”.  So dramatically has the market landscape changed that an investment banker or hedge fund manager waking from a Rip Van Winkle snooze would react to ZIRP, QE and Twist by clicking the sell button (of course, he or she would have first tried to call their floor broker only to learn they were replaced by an algorithmic trading computer).

Monetary policy makers have become so ingrained that imagining smoothly functioning markets without them is the same as imagining the Jets winning the Super Bowl.  Federal Reserve activism began to increase in the 1990’s.  Global central banks intervened as a response to 1997’s Asian Crisis by cutting interest rates and expanding the supply of money.  This easing then contributed to the Dot-Com bubble which eventually burst and was fought with more money printing and lowering of interest rates.  In turn this contributed to the housing and credit crisis which led to the current state of quasi-free markets.

Coming out of the Great Recession, the markets initially disliked this stepped-up intervention but changed their mind as they accepted it as necessary to save the system (a debatable issue).  Since then investors have become so comfortable with the Fed’s finagling that they look forward to any “Fedspeak”.  Now, every speech by a Federal Reserve board member is scrutinized for a sign of policy adjustment.  Every press conference and testimony is broadcast on the financial networks.  Indeed things have changed.

Yet this change in perception goes almost unnoticed.  Perhaps it’s analogous to a frog being placed in the pot before the burner is turned on – the change is imperceptible but becomes drastic over time.  Perhaps it’s a function of the wave of younger traders and managers who accept this new environment as natural and can’t imagine the economy working without the Fed’s current role.  Whatever the cause, there is widespread belief that the Fed’s intervention is needed and is a benefit.

Financial details like earnings growth, margins, and cash flows remain important.  However, in the modern investing world they are trumped by central bank policy.  To be sure, monetary stimulus or tightening will impact virtually every company’s performance. However, the degree and speed with which the market judges a verb or adjective’s impact on our almost $16 trillion economy is lunacy.

During Chairman Bernanke’s May 22nd congressional testimony, he stated that daily bond purchases might be “tapered” beginning in September.  The words barely hit the tape and stocks plunged.  The Dow Jones Industrial Average, which had reached a new high before his appearance, reversed course and fell 235 points.  The 10-year treasury note’s yield spiked to above 2.04% from the morning’s 1.88%.

“Taper” was suddenly the word on everyone’s lips and the debate over whether we had finally reached the end of quantitative easing began.  The stock market reversal ushered in a 2013 rarity – a three day losing streak.  Stock chopped around for the next two weeks trading lower 7 out of the next 10 days.

While stocks fell over 6% during the month, the real pain was in the fixed income market.  Interest rates started rising at the beginning of May moving from 1.63% on the 10-year note to the 2% level after Bernanke’s testimony.  The yield eventually topped out above 2.7% in early July.  20% losses were common in the bond mutual fund sector and it was a shocking wake up for those who thought fixed income investing provided stability.

U.S. stocks have recovered aided by what else but soothing words by Ben Bernanke.  In June, the fed chairman reassured the markets that “The overall message is accommodation.”[1]  Equities rebounded in late June and resumed this year’s pattern of slowly and steadily climbing with the Dow, S&P 500, and Russell 2000 making new all-time highs last week.  Here are the major indexes’ year-to-date returns through last week.

                                                                                    2013[2]

Dow Jones Industrial Average                                    +18.6%
S&P 500                                                                      +18.6%
Nasdaq Composite                                                      +18.8%

Russell 2000                                                                +23.7%

Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividends

While U.S. stocks are having a very good year, there are other areas with negative returns.  The underperformance of the emerging markets is a development that has gone somewhat unnoticed.  At the end of last week Brazil had fallen 22.8% this year while the Chinese Shanghai Composite is down 12.2% and Russia has declined 9.6%.[3]

Fighting the fed is a perilous occupation.  Equally hazardous is blindly following central bank rhetoric.  The degree to which the Bank of Bernanke influences the direction of the markets is remarkable.  That this is a recent phenomenon matters little except to add another influence and perhaps increase risk.  The risk primarily surrounds the fact that so many are trading the same way.  When everyone trades the same way, it inevitably leads to an excess which results in a painful adjustment.

There are many smart strategists who believe quantitative easing is far from being over (see Pimco’s Mohamed El-Erian June 14, 2013 Financial Times article).  While this market tailwind will continue to a positive for risk assets, it is not solving all problems.  The ongoing Europe saga remains without a solution with unemployment in the southern European countries at alarming levels.  The Middle East is in turmoil and global growth is slowing (the OECD industrial production is contracting year-over-year).

Perhaps most troublesome is the recent spike in interest rates.  Possibly rates retrace this jump higher but, if not, it could be an economic growth obstacle.  The rise in nominal rates (the stated rate) has caused real rates (nominal rate minus the inflation rate) to dramatically increase.  This type of move in real rates often can slow economic activity.  Maybe this is what’s disturbing the emerging stock markets.

There are some market pros who are pointing to 2013’s move as a beginning of a huge multi-year bull market.  While this is possible (and the Fed certainly is rooting for it), stocks rarely move in one direction forever.  A normal cycle has corrections and pauses.  This year has been an exception.  Other than the June pullback, the averages have steadily climbed.

However, there are a few signs that we are getting closer to a dip.  Sentiment is at a minimum complacent, but can be considered overly bullish.  Rising prices have pushed valuations beyond what can be considered cheap.  At recent record levels, the indexes are encountering significant resistance.

If a correction occurs, it might be an opportunity.  Presuming a normal pullback that has little economic impact, lower prices should encourage buying which could setup a good end to the year.  In the meantime, traders’ summer reading includes Federal Reserve meeting minutes.